Topic 1 (Pt2) - Intro to Financial Markets Flashcards
How to calculate monetary returns?
Profit = Dividends + Capital gains
= Div1 + (P1-P0)
What are the different ways return can be expressed?
- Monetary returns (cash returns)
- As a percentage
- As a decimal
How to calculate returns as a percentage?
(Div1/P0 + (P1-P0)/P0)) x 100
What does the mean give?
An average over a period of time
What is variance?
- Variance measures spread from the mean
- This volatility provides an indication of the risk an investor may be exposed to when purchasing an asset
- Large variance = large deviations from the mean
Formula for variance
1/T sum of (r-mean)^2
What is the probability theory?
Where a crisis is an accumulation of little shocks that didn’t all happen at once. We can calculate the probability of those shocks occurring
What does the probability theory assume?
Probability theory assumes that
variables are normally distributed
But random variables have a habit of not behaving that way,
especially in finance.
The normal distribution underestimates the probability of extreme values, both positive and negative. Crisis indicates our failure to consider these outliers
What properties should stock prices have in an “Efficient” market?
- random, unpredictable
- prices should react quickly, correctly and fully to news
- Investors cannot earn abnormal, risk-adjusted returns
What newly available information can affect the firm?
Global climate, state of the economy, firm health
What does more volatile returns mean?
The more volatile returns, the more unpredictable future returns are, and the greater the risk (upside/downside).
What causes asset price volatility?
- Natural disasters, demand and supply conditions, inflation ….
- Fear and panic - mass buying and selling that isn’t driven by market conditions
What are 3 things to consider when looking into stock market efficiency?
- Magnitude issue
- Selection bias
- Lucky event issue
What are 3 things to consider when looking into stock market efficiency (MAGNITUDE ISSUE)?
Only managers of large portfolios can earn enough trading profit from mispricing.
◦ Hence it is investment managers whose trades drive stock prices towards their fair price.
What are 3 things to consider when looking into stock market efficiency (SELECTION BIAS)?
Those that have discovered investment strategies that generate
abnormal returns are unlikely to share them
What are 3 things to consider when looking into stock market efficiency (LUCKY EVENT ISSUE)?
Some investors will be lucky-‘winners’
What are financial returns?
We can expect to earn a certain amount for holding an asset, however the actual return can be lower/higher than this expectation.
The expectation could be based on average past return or using the firm prospects.
Monetary returns take into account dividend income and capital gains.
GIVE FORMULA and annotate that dividends could be zero and capital gains can be negative
Summarise Risk and return
Average return over a period provides an indication of past performance and thus potential future performance.
FORMULA FOR MEAN
The variance of an asset’s return shows the spread of returns from its mean, and thus provides a measure of volatility and therefore risk, with higher variances indicating greater volatility
FORMULA FOR VARIANCE
Systematic risk aka market risk
- This comes from the entire market, and affects all assets in that market.
For this reason, this risk cannot be reduced by simply holding a diversified portfolio
EXAMPLES: natural disasters, economic crisis, wars
Different assets may be affected differently, with some sectors affected more adversely than others, but the entire market feels the impact
